Query No. 16

Subject:           Determination of stage of completion in construction contracts.[1]

Facts of the Case 

1.         A company was incorporated under the Companies Act, 1956 on 24.05.1980.  It is a state public sector undertaking (PSU) and is owned by the Government of Odisha. The total paid-up equity capital of the company is Rs. 5.63 crore, which is entirely held by the Government of Odisha.  The company is an unlisted public company.

2.         The primary objects of the company are as follows:

(i) To undertake construction of buildings for the housing of police personnel of the Government of Odisha.

(ii) To formulate and execute housing schemes for the benefit of serving police personnel of the Government of Odisha.

(iii) To undertake construction of buildings for residential and non-residential purposes for the police, vigilance, prison and fire service departments of the Government of Odisha.

(iv) To undertake construction of buildings necessary for conducting schools, hospitals, clubs and other welfare measures for the benefit of the police personnel of the Government of Odisha.

3.         The querist has stated that the head office of the company is located at Bhubaneswar, the state capital of Odisha. There are nine divisions spread all across Odisha to execute the works. Each division is headed by a civil engineer with a rank of executive engineer and designated as Joint Manager / division head. The company executes projects spread all over Odisha through these nine divisions. The average number of projects executed by the company is more than two thousand at any time during  a year (emphasis supplied by the querist).

4.         The querist has further stated that since  the company has  been incorporated  specifically for execution of projects of  Home Department of the Government of Odisha, it does  not participate in tender for obtaining orders from various  Government  departments (called as user departments). The procedures of obtaining orders from user departments are as follows:

(a) The Government departments,  that  intend  to  undertake  a  project, request the company  to  submit  an  estimate  for  the project  as  per Odisha Public Works  Department (OPWD)  Schedule  of  Rates (SoR).

(b) The company prepares estimates as per OPWD SoR and submits them to the user departments. These estimates include costs of material, labour, other overheads and supervision charges of the company. The  amount  of  supervision  charges  are  calculated  at  a  certain  percentage  of  estimated  project  cost (presently 10%  of  estimated  cost). The  supervision  charges  are  included  in  the  project  estimate to  meet  the  salary, administrative  and  other  overheads  of  the company as it does  not  get  any  budgetary  support  from  the Government.

(c) Upon  getting  the  estimates, the  user  departments  accord  approval  for  the  project,  known as ‘Administrative Approval’ and  release the  funds  limited  to  the  amount  of ‘Administrative  Approval’.

(d) OPWD SoR are  uniform for  projects spread  all  over  Odisha, whereas,  the  market  prices  of  material, labour and other  overheads  vary  from  location  to  location  and are generally higher  than  the OPWD SoR.

(e) Contract value is fixed to the amount of ‘Administrative Approval’ received. Contract  value  will  not  be  increased  unless  otherwise  the  scope  of  work  increases  and  the  cost  overrun, if  any,  attributable  to  the  user  departments.

(f) After receipt of  Administrative  Approval, the company decides to  execute  the  project  either  of  its  own,  known  as  departmental  execution (Contract K-2)  or  through  e-tender  process ( Contract F-2).

i. Under  K-2,  divisional  heads  of the company procure  materials  and  engage  labour  contractors  for  execution  of  the  project. Costs of materials and labour  are  finalised  through yearly  tenders.

ii. Under F-2, the company invites open tenders and allots the project to eligible contractor on a turnkey basis.

g. Once it is  finalised whether  the  project  is  to  be  executed  under  K-2  or  F-2,  work  orders  are  accordingly  issued  to  the  respective  division  head  for  execution  either under  K-2  or  to the eligible contractor  for  execution  under  F-2.

h. Subsequently, works  are  executed  as  per  work  orders  issued  under  K-2  and  F-2   and  handed  over  to  the  clients / user agencies  after  completion.

i. Due to variation in  the  market  price  and  estimated  price of construction  cost (material, labour  and other overheads) of  a project,  the  outcome  of  a  project cannot be estimated  reliably  unless  and  until  the  project  is  completed  and  handed  over.

5.         Revenue recognition by the company:

The contracts executed by the company are in the nature of fixed price contracts. Since  the company is  executing  more  than  2000  projects  at  a time,  it  is  not  practically  possible  for  the company  to  estimate  the  contract  cost  to  complete  the  balance  work  and calculate  the  stage  of  contract  completion  as  on the balance sheet  date. Further, since there  is  no  correlation  between  the  estimated  cost  and  actual  cost  of  execution,  it  is  not  practically feasible  to  derive  the  outcome  of  such  huge  number  of  projects  unless  and  until  the projects  are  completed  and  handed  over  to  the  user  departments.

6.         Due  to  the  aforesaid  reasons, the company is  recognising its revenue and  expenditure in  its  annual  financial accounts  as  per paragraphs 31(a), 31(b) and 32 of Accounting  Standard (AS) 7, ‘Construction Contracts’, issued  by the Institute of Chartered Accountants of India (ICAI) as follows:

(i) Revenues are   recognised only to the extent of contract costs incurred of which   recovery is probable.

(ii) Contract costs are recognised as expenses in the period in which they are incurred.

(iii) Amount of surplus or deficit  in  a particular  project  is  not  included  in  the revenue  of  that project,  during  a  particular  year,  unless  and  until  the  project  is  completed  and handed  over to  the user departments.

(iv) As  per  past  records,  the  actual  surplus  of  projects  never  matches  with  the  surplus  mentioned  in  the  estimate  and  there  are  cases  where  the  projects  have  ended up  with  losses/deficit  inspite  of  surplus  stated  in  the  estimate.

The following are the few Police Station (PS) buildings executed  by the company, where  the contact value  and  estimated cost are  same  but  the  outcome  of  the  projects  are different:

7.         Opinion of statutory auditors:

(a) The  statutory auditors of the company, appointed  by the Comptroller and Auditor General (CAG) of India, are  of  the opinion  that  since  surplus / margin is not included  in  the revenue  of  on-going  (non-completed)  projects  in  the annual  accounts, the company is failing to comply with Accounting  Standard (AS) 7, ‘Construction Contracts’, issued  by the ICAI.

(b) The statutory auditors are insisting  for:

(i) physical  measurement  of  all projects,  which  are  more  than  2000 in numbers.

(ii) valuing  the  percentage  of  completion  on  the  basis  of  original  estimate, and 

(iii) including  estimated  surplus  in  the  revenue  of  non-completed  projects,  which, as per the querist, is not  practically feasible to  derive correctly.

8.         The querist has also provided an illustrative example of revenue recognition by the company for the perusal of the Committee which is given below:

Example

During  the  financial  year  (F.Y.) 2011-12, the company was  awarded  for  construction of  four  police  stations  at  different  locations  of  the State,  by  Police  Department of  Government of  Odisha. Estimates  for  these  projects  were  prepared  on  the  basis  of  SoR  of  2011. Estimated costs of these projects are as follows:

Rs. In Lakh

Projects A & B  were  supposed  to  be  completed  and  handed  over  during  the  F.Y. 2011-12  and  Projects  C & D  were  supposed  to  completed  and  handed  during  the  year  2012-13. Actual costs incurred on various projects during the F.Y.  2011-12 & 2012-13 are as follows:             

Rs. in Lakh

Recognition of  revenue and  expenditures  made  by the company in  the  accounts  of F.Y. 2011-12  are  as  follows :

Statement of Profit and Loss  of the company  for F.Y. 2011-12

Note:

Since Projects C  and  D  have  not  been  completed  it  is  not  practically  possible  to  ascertain  whether  the  projects will  have  any  surplus  or  not, therefore, contract  costs which  are  recoverable  have  been  taken  as  revenue.

Recognition  of  revenue  and  expenditures  made  by  the company in  the accounts  of F. Y. 2012-13 are  as  follows :

Statement of Profit and Loss of the company for F.Y. 2012-13

Note:

1. Revenue  of  Project C  is  arrived  at Rs. 35.00 lakh  after  reducing  the  turnover  of  Project C taken  during  the  year  2011-12 i.e., Rs. 75.00 lakh  from  the  contract  value  of  Rs. 110.00 lakh.

2. Revenue  of  Project D  is  arrived  at Rs. 42.00 lakh  after  reducing  the  turnover  of  Project D taken  during  the  year  2011-12 i.e., Rs. 68.00 lakh  from  the  contract  value  of  Rs. 110.00 lakh.

B.        Query

9.         On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee as to whether the  accounting procedure  followed  by the company for  recognition  of  revenue and expenditure, which, as per the querist, are as  per paragraphs 31(a), 31(b) and 32 of AS 7, is in conformity  with  AS 7 or  not.

C.        Points considered by the Committee

10.       The Committee notes that the basic issue raised by querist relates to whether the accounting procedure currently followed by the company for recognising revenue and costs is in conformity with AS 7 or not. The Committee has, therefore, considered only this issue and has not considered any other issue that may arise from the Facts of the Case.   The Committee presumes from the Facts of the Case that the contracts in the extant case are separate and independent fixed price contracts.

11.       The Committee notes from the Facts of the Case that the company, on the basis of inquiry received from various Government departments, submits estimates for each project separately as per Odisha Public Works Department (OPWD) Schedule of Rates (SoR). The estimates are submitted after including cost of materials, labour, other overheads and supervision charges which includes its profit margin. The Committee further notes that the querist has stated that the company is following paragraphs 31 and 32 of AS 7 as the outcome of the construction contracts in its case cannot be estimated reliably. In this regard, the Committee notes the following paragraphs of AS 7, notified under the Companies (Accounting Standards) Rules, 2006:

“21.       When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date. An expected loss on the construction contract should be recognised as an expense immediately in accordance with paragraph 35.

22.         In the case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all the following conditions are satisfied:

(a) total contract revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the contract will flow  to the enterprise;

(c) both the contract costs to complete the contract and the stage of contract completion at the reporting date can be measured reliably; and

(d) the contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates.”

“28.       An enterprise is generally able to make reliable estimates after it has agreed to a contract which establishes:

(a) each party’s enforceable rights regarding the asset to be constructed;

(b) the consideration to be exchanged; and

(c) the manner and terms of settlement.

It is also usually necessary for the enterprise to have an effective internal financial budgeting and reporting system. The enterprise reviews and, when necessary, revises the estimates of contract revenue and contract costs as the contract progresses. The need for such revisions does not necessarily indicate that the outcome of the contract cannot be estimated reliably.”

“31.       When the outcome of a construction contract cannot be estimated reliably:

(a) revenue should be recognised only to the extent of contract costs incurred of which recovery is probable; and

(b) contract costs should be recognised as an expense in the period in which they are incurred. 

An expected loss on the construction contract should be recognised as an expense immediately in accordance with paragraph 35.

32.         During the early stages of a contract it is often the case that the outcome of the contract cannot be estimated reliably. Nevertheless, it may be probable that the enterprise will recover the contract costs incurred. Therefore, contract revenue is recognised only to the extent of costs incurred that are expected to be recovered. As the outcome of the contract cannot be estimated reliably, no profit is recognised. However, even though the outcome of the contract cannot be estimated reliably, it may be probable that total contract costs will exceed total contract revenue. In such cases, any expected excess of total contract costs over total contract revenue for the contract is recognised as an expense immediately in accordance with paragraph 35.”

“35.       When it is probable that total contract costs will exceed total contract revenue, the expected loss should be recognised as an expense immediately.”

12.       The Committee notes from the Facts of the Case that the querist has stated two reasons for the company not being able to measure the outcome of the project reliably. Firstly, it is stated that the company is executing large number of projects due to which it is not practically possible to estimate the contract cost to complete the balance work and calculate the stage of completion as on the balance sheet date. Secondly, it is stated that since there is no correlation between the estimated cost and actual cost of execution due to estimates being based on SoR, it is not practically feasible to derive the outcome of such huge number of projects unless these are completed and handed over to the user departments.

13.       As far as the first reason for not measuring the outcome of the project reliably due to practical difficulties of having large number of projects is concerned, the Committee notes that AS 7 identifies certain situations/conditions in paragraphs 22, 28 and 32, where, in fixed price contracts, it can be stated that the outcome of the project cannot be estimated reliably. The Committee notes that as per AS 7 in case of fixed price contracts, ordinarily, the company would be able to estimate the outcome of the contract reliably except in certain situations, for example, in early stages of a contract and, therefore, should recognise contract costs and revenue based on stage of completion of the contract. The Committee also notes that as per the provisions of AS 7, stage of completion of a contract can be determined either by reference to the contract costs incurred or by reference to physical completion of the contract using survey of work performed or completion of a physical proportion of the contract work method. The Committee is of the view that only practical problems due to large number of projects cannot be considered as a ground for not being able to estimate the outcome of the contract reliably as even in large number of projects where the stage of completion is being determined by reference to contract costs incurred, the company, on the basis of estimates of various costs, such as, labour, material, etc. would generally be able to reasonably estimate the outcome of various projects.  However, for this purpose, in order to overcome the practical difficulties due to large number of projects, the company should develop an effective reporting system from all the projects to obtain the data required at the head office for determining the stage of completion as per AS 7.  

14.       As far as the second reason of no correlation between the estimated cost and actual cost of execution of the contract, the Committee is of the view that although for submission of an estimate for a project to the Government departments, it might be essential for the company to use the rates given in SoR, for the purposes of implementation of AS 7, estimates should be based on the costs expected to be incurred on the project and should also be revised from time to time depending on the changes in the circumstances. The Committee is of the view that for this purpose, the company should develop an effective budgeting system so as to have the reliable data available for estimating the outcome of the contracts at any stage and for determining the stage of completion. The Committee is of the view that a proper budgeting and reporting system is not only required from the angle of implementation of AS 7 but is also necessary to effectively manage various contracts.

15.       The Committee further notes that the querist has stated that the amount of surplus or deficit in a particular project is not included in the revenue of that project, during a particular year, unless and until the project is completed and handed over to the user departments. As per past records, the actual surplus of projects never matches with the surplus mentioned in the estimate and there are cases where the projects have ended up with losses/deficit inspite of surplus stated in the estimate. Hence, it can be inferred that where there are expected excesses of total contract costs over total contract revenues for the contracts, these have not been recognised immediately as per the above-reproduced paragraphs 31, 32 and 35 of AS 7. In this regard, the Committee wishes to point out that any expected loss on the contract should be recognised immediately as an expense in the statement of profit and loss.

D.        Opinion

16.       On the basis of the above, the Committee is of the opinion that the accounting procedure followed by the company is not in accordance with the requirements of AS 7, as discussed in paragraphs 12 to 15 above. The Committee is of the view that to overcome the practical difficulties due to large number of projects, the company should develop an effective reporting system from all the projects to obtain the data required at the head office for determining the stage of completion as per AS 7. With regard to company presently having no correlation between the estimated cost and actual cost of execution of the contract, the Committee is of the view that for the purposes of implementation of AS 7, estimates should be based on the costs expected to be incurred on the project rather than based on the rates given in SoR, and for this purpose, an effective budgeting system should be developed, as discussed in paragraph 14 above.

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[1]Opinion finalised by the Committee on 6.6.2014.